Risk Arbitrage

See: Arbitrage.

MegaFood Inc., a massive grocery story chain, agrees to purchase Greta's Garden Grocery, a local chain of produce boutiques in the Pacific Northwest. MegaFood is going to buy the company in stock-for-stock merger, trading its stock for shares of Greta's.

The deal calls for MegaFoods to exchange it's shares 1-to-2 for Greta's, so that Greta shareholders will receive 1 share of MegaFoods for every 2 shares they own of Greta's. At the time the merger is announced, MegaFoods is trading at $31 and Greta's is trading at $10...though it immediately jumps to $14 on the news.

Now, eventually, those prices will converge. As long as the deal closes, two shares of Greta's will be worth the same amount as a single share of MegaFoods. We know this...because that's the deal the companies struck. On the day the merger closes, each Greta shareholder can swap two of their shares for one share of MegaFoods. So if Greta's is trading at $14, then MegaFoods should be trading at $28. Or, if MegaFoods is trading at $31, then Greta's should be trading at $15.50. But they aren't. There's a bit of a mismatch. Room for some risk arbitrage.

There can be a couple reasons the shares don't jump directly into complete alignment. One is just market inefficiency. But the biggest cause has to do with uncertainty about the deal closing. The chances might be small, but there's still a possibility that something will scuttle the deal. Regulatory issues. Shareholders voting against the deal. Another bidder coming in. Lots of things can happen.

A risk arbitrager bets that those things won't happen. They bet that the deal will go through, and that the value of the stocks will come into alignment. As such, they will buy shares of the target company (Greta's in this case) and short shares of the acquiring company (MegaFoods here). Either Greta's will rise to match the proper price of the MegaFoods shares, or MegaFoods will fall to reach alignment of Greta's. Or...a little of both will happen.

Whatever the case, as long as the deal goes through, the risk arbitrager makes money.